China’s newest threat: Zombie companies

In a bit of life-imitating-art serendipity, “The Walking Dead” is a huge hit in China just as the nation faces its own onslaught ― of zombie companies.

Today, China’s 1.3 billion people got their first glimpse of the undead as Shanghai Chaori Solar Energy Science & Technology shuffled out of the shadows. According to the Wall Street Journal, the solar-equipment maker scared up China’s first domestic corporate bond default. You don’t have to be a fan of cable television channel AMC’s show or this most-trafficked of Hollywood genres to know that where there’s one zombie, there are whole armies of them. Japan proved that well enough.

How President Xi Jinping handles the swarm will decide whether the Communist Party’s pledges to internationalize China’s financial system are real or mere fiction. I’m a bit doubtful that Xi can muster the political will to let start letting much bigger zombies fall.

Definitions for zombie companies vary, but many China observers look at those with debt loads that double equity. Their ranks have surged since the global crisis. According to Bloomberg News, publicly traded non-financial companies with debt-to-equity ratios exceeding 200 percent jumped 57 percent to 256 from 163 in 2007.

Beijing’s willingness to let Shanghai Chaori Solar renege on debt is good news, as these things go. While destabilizing for bond holders and the interest-rate environment in the short run, bond defaults are a vital cleansing process from which markets learn, mature and become more efficient. In China’s case, such events are especially needed to police borrowing activities and help investors price credit risks.

At the moment, no one knows the true state of bond-market risks in China because of opacity, the outsized role of the shadow-banking system and a basic inability to discern where the Communist Party ends and state-owned enterprises begin ― never mind the nascent private sector. Western officials harp about the evils of moral hazard, whereby bad business practices are enabled by public institutions. But China’s entire financial system is one where there’s long been no price to pay for dodgy lending and borrowing decisions.

The symbolism of Chaori Solar’s default on a $15 million bond coupon due today could be huge. Or it could be just at aberration. Let’s hope it’s the former. But how will we know? When China allows much larger defaults in the bloated sectors that need it most: building materials, coal, metal, mining, steel and, of course, solar. China’s finance industry also requires a significant purge in the years ahead.

On Feb. 10, Xia Bin, a former adviser to the People’s Bank of China and now an adviser to the State Council, said it’s inevitable some “zombie” companies will fail as the central bank normalizes monetary policy. But that would require a much greater tolerance to inflict pain than either Xi or Premier Li Keqiang has displayed so far.

Bank of America’s China strategy team calls this a “Bear Stearns moment” for China. The default, they argue, will prompt investors to reassess credit risks as they did after the U.S. securities firm crashed in 2008. The risk now is a chain reaction of the kind that coursed first through Wall Street and then the global financial system. During the U.S. crisis, it took many months to reach the panic point as Lehman Brothers went bust and credit markets seized up. China may be entering into such a period.

I’m just not convinced Beijing will entertain that risk. The simple fact that Xi and Li are committing themselves to 7.5 percent growth in 2014 to maintain social stability argues against it. Sure, we may see a couple of bigger defaults in the weeks or months ahead. But until China allows one of the magnitude of say, Detroit’s $18 billion collapse, my sense is China’s walking dead will see more public bailouts than bankruptcy documents.